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Sri-Kumar: Europe in Recession in Next 6 Months

Christine Benz

Christine Benz: Hi. I am Christine Benz for Morningstar. The eurozone's woes have recently roiled global markets. Here to discuss the implications for U.S. investors is Komal Sri-Kumar. He is chief global strategist for TCW.

Komal; thanks so much for joining me.

Komal Sri-Kumar: Thank you for inviting me, Christine.

Benz: So, Komal, the French president and the German chancellor recently had a meeting to discuss how to resolve the debt problems that have been plaguing the eurozone. Do you think that they moved forward at all? Did they come up with any reasonable solutions to what's troubling the eurozone?

Sri-Kumar: Christine, I think there has been a lot of talk on the euro debt situation beginning with the Greek bailout on May 10. This is one more in the instance of conversations going on without getting much achieved, and one of the major decisions they made was to name the head of a eurozone, for instance. It just introduces more bureaucracy but essentially did not achieve much at all. I would just mention one thing: The big thing that markets were waiting for was to see whether euro bonds were going to be issued which would become a German obligation finally because that is the most credit-worthy country, and obviously that did not come through either. I called my paper today as "Much Ado About Nothing" because I don't think they achieved enough.

Benz: So, another question that I think investors have been thinking about in eyeing Europe is, what's happening with growth because we've recently begun to see signs that even what had been perceived to be relatively healthy countries, Germany and France, in terms of growth appear to be slowing down, as well. What's your take on those countries?

Sri-Kumar: There is a marked deceleration in growth from the first to the second quarter. In the first quarter, for example, Germany grew at 5.3% pace at an annualized rate and that was down to a mere 0.4% in the second quarter. French growth essentially was flat. There was no growth at all. What it says to me is that Germany and France which used to be the motors of economic growth and also large members of Core Europe have slowed down substantially, and I think what we are looking at is the likelihood of a serious European recession to follow in about three months' to six months' time. They may already be in a recession in the third quarter, but if not I am looking at a fourth-quarter beginning of a European recession.

Benz: So, how should that affect how U.S. investors think about their portfolios? They obviously want to gauge how much of their foreign stock positions our staked in Europe, but what do you think the spillover effects are or might be for U.S. companies if there is a recession unfolding in Europe within the next several months?

Sri-Kumar: Let me take your question in two parts. I think I would look at the implication for U.S. multinational corporations with a European presence, and I will look at U.S. investors thinking of investing in European equities.

The first case, the U.S. multinationals have been doing well in terms of corporate earnings for the last several quarters; one reason has been the strength of the Western Europe. Core Europe is a lot bigger and a lot more important than Fringe Europe, so it did not matter what happened to Greece, Portugal or Ireland, to the extent Germany was doing well. That is I think going to be reversed. So, my feeling for a long time has been that U.S. corporate earnings have been growing much faster than justified by the U.S. economic outlook. Now I think corporate earnings growth is going to slow, one reason being what we see happening in Europe.

Secondly, from the point of view of U.S. investors, I think they should wait until there is some form of recognition of the seriousness of the European debt crisis by the Europeans, which I think we don't have so far. And when there is a significant decline in debt prices and equity prices, only then should they go into it. At the moment, I would say the presence in European debt and equity should be close to zero.

Benz: So, I think a related question is that a lot of people have been watching growth slow here in the U.S. as well, and now there are concerns about a slowdown in Europe. A lot of people are looking to emerging markets as the bright shining example of where growth is right now and may continue to be in the future. Is there a risk that those markets could become overheated and that you'd have a lot of capital stampeding into emerging markets and the valuations just would not be comfortable at that point?

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Sri-Kumar: I don't see much of a risk of substantially more overheating in emerging markets, Christine, and the reason is that they are taking steps in terms of tightening policies, that's the first one; and second, the major emerging countries are already slowing down in terms of their economic growth. We see that with some of the recent Chinese numbers and the fact that they have continued to increase interest rates, those things are also going to the discourage capital inflows coming in.

So, I don't see the money leaving the United States and Western Europe and trying to look for a position in emerging markets as much as the money is going toward gold, it is going toward commodities, it is going toward Swiss francs. It is being more defensive. Just to be very clear, some of the money is going to go into emerging markets, but I don't think the bubble is all forming in emerging markets, but it is forming in a whole lot of inflation-resistant and developed-country recession-resistant areas and emerging markets are only one part of the equation.

Benz: So, finally, I'd like to get your take on what do you think will bring a resolution to the European debt crisis? What steps have to happen to put those countries on a better path?

Sri-Kumar: That's a good question, Christine. I begin by saying, why do we have a European debt problem? We have a European debt problem because there is an excessive amount of debt, so the remedy or cure needs to involve a reduction in the level of debt whereas the Greek, Portuguese, and Irish bailouts all have involved increasing the amount of debt and worsening the debt/GDP ratios.

So, what Europeans need to do much as the Brady Plan did for Latin America starting in 1989 is to look for a way to reduce the amount of debt by exchanging them for discount bonds, low-interest-rate bonds, and allowing debt-to-equity conversions to a level that the debt can be serviced. And the Europeans haven't taken even a single step toward it, so I think that remedy, which will work, is very much in the future.

Benz: OK. Well, thank you, Komal, so much for sharing your insights. We very much appreciate you being here.

Sri-Kumar: Thank you, Christine.

Benz: Thanks for watching. I am Christine Benz for